Why has the FED offered to exchange U.S. Treasury securities for mortgage backed securities…..?
by Mortgage Rates on Tuesday, September 14th, 2010 | 2 Comments
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To stave off a total economic collapse similar to the great depression.
the fed is assuming the risk that the banks took on in making those loans.
if the fed takes on this risk, then the banks will not suffer the losses due to those loans defaulting; leading to more confidence in the financial system.
confidence in the financial system is important as banks are the ones who fund economic growth by lending to projects which increase the economy’s output. if the banks do not lend, the economy cannot grow. the fed is fearful that because of the risk the banks have taken in the past they will not be able to lend to worthy investment now.
the fed thinks that if the risk is taken away from the banks then they can reorganise themselves and begin lending to profitable projects again; pulling the american economy out of its slump.
the downside is that the fed has taken on those risks; rather then the shareholders of the banks which took risking loans to increase their profits. this is called moral hazard.
the banks make risky loans, believing if they go bad they will get bailed out by the central bank; so therefore make more risky loans then they should.
the risk is shifted from the individual banks and their shareholders to the federal bank and the taxpayers.
in effect the american tax payers are bailing out shareholders of banks after the banks made incorrect risk assessments and made bad loans.
the british central bank is refusing to bail out bad lenders, in an opposite stand to the fed.
the fed therefore see financial market confidence as being more important then the moral hazard of bailing out previous bad decisions; the bank of england has decided the opposite (at this time).
while it is a good move short term – in the long term it only encourages banks to undertake further risky loans as the underlying belief that the fed will bail them out reduces their risk compared to the reward of making such risky loans.